Bond markets tell a different story

Bond Market to Bernanke: Recession Threat Means More Rate Cuts

By Daniel Kruger

Nov. 19 (Bloomberg) -- The headline in the financial futures market these days says Federal Reserve Chairman Ben S. Bernanke is withholding some vital information: The economy is so bad the central bank will have to lower interest rates at least three- quarters of a percentage point to avoid a recession.

Bernanke's two rate cuts since September failed to reassure the bond market, where volatility has risen four of the past five weeks, according to Merrill Lynch & Co.'s MOVE Index. Yields on Treasury bills, the haven for bond investors in times of turmoil, are near their lows of August, when losses on securities backed by subprime mortages froze credit markets.

While the record low dollar and the fastest inflation in 14 months give policy makers reasons to keep the target rate for overnight loans between banks at 4.5 percent, traders expect 3.75 percent early in 2008. Interest-rate futures on the Chicago Board of Trade show the Fed will cut borrowing costs in December and again in the first quarter, as the worst housing slump since 1991 deepens and retailers including J.C. Penney Co. and Macy's Inc. forecast slumping sales.

Investors are sending the message to Bernanke that ``you're wrong and we're going to lead you to the next ease,'' said Thomas Tucci, head of U.S. government bond trading in New York at RBC Capital Markets. The firm is the investment-banking arm of Canada's biggest bank.

Fed fund futures show traders see a 90 percent chance the central bank will reduce its target a quarter-percentage point to 4.25 percent at its Dec. 11 meeting, 67 percent odds of another 25-basis-point cut in January, and a 43 percent likelihood the rate falls to 3.75 percent in March. Policy makers already lowered the target from 5.25 percent in August.

Worse than LTCM

The Fed hasn't cut that much since 2001, when the economy shrank and policy makers lowered rates 11 times. Even when Russia defaulted and Long-Term Capital Management LP collapsed in 1998, policy makers only had to reduce rates 75 basis points.

The yield on the benchmark two-year note, the security most sensitive to rate expectations, fell 8.5 basis points last week to 3.34 percent, according to bond broker Cantor Fitzgerald LP. The price of the 3 5/8 percent Treasury due in October 2009 rose 4/32, or $1.25 per $1,000 face amount, to 100 17/32. The benchmark 10-year note yield declined 5 basis points, or 0.05 percentage point, to 4.17 percent.

Bernanke suggested the central bank is reluctant to lower rates again when he told Congress on Nov. 8 that the economy will likely ``slow noticeably'' this quarter while also citing ``upside risks'' to inflation. Fed Governor Randall Kroszner was more pointed, saying in a New York speech on Nov. 16 that ``the current stance of monetary policy should help the economy get through the rough patch during the next year.''

Stiglitz `Pessimistic'

Financial markets aren't buying it. Wells Fargo & Co. Chief Executive Officer John Stumpf said at a Merrill Lynch conference in New York on Nov. 15 that the housing market slump is the worst since the Great Depression.

Joseph Stiglitz, the Columbia University professor and Nobel-prize winning economist, said there is a 50 percent chance of a recession in the U.S. as a worldwide increase in credit costs following the collapse of the subprime mortgage market chokes off financing. ``I'm very pessimistic,'' Stiglitz said in an interview in London Nov. 16.

Financial companies may lose as much as $400 billion because of home foreclosures, based on a ``back-of-the-envelope'' calculation, Jan Hatzius, chief U.S. economist at Goldman Sachs Group Inc. in New York, wrote in a report last week. That will force banks, brokerages and hedge funds to cut lending by $2 trillion, he estimated.

Bill Yields

Merrill's MOVE index reached 112.08 on Nov. 9, the highest since Sept. 20, and was at 99.14 on Nov. 16. The gap between yields on three-month bills and the Fed's target rate widened to 1.25 percentage points, the biggest gap since Sept. 14. Bill yields fell as low as 3.16 percent on Nov. 15, near this year's low of 3.09 percent on Aug. 20.

For the first time since 2001, yields on Treasuries maturing from three months to 10 years are below the federal funds rate. Five of the past six times that has happened, the economy entered a recession, data compiled by Bloomberg show.

Most analysts don't expect a recession. After annual growth of 3.9 percent from July to September, the economy will cool to a 1.5 percent pace this quarter and expand 2 percent in the first three months of 2008, according to the median estimate of 72 economists surveyed by Bloomberg from Nov. 1 to Nov. 8. The Fed will cut its target to 4.25 percent next quarter and leave it there through 2008, a separate survey shows.

Faster Inflation

Faster inflation is making Bernanke's job tougher. Consumer prices rose at a 3.5 percent annual rate in October, the most in 14 months, the Commerce Department said Nov. 15. Crude oil soared 56 percent this year, reaching a record $98.62 a barrel. The dollar sank to a record low of $1.4752 per euro on Nov. 9 and import prices rose 1.8 percent in October, the most in 17 months, the Labor Department said.

``It seems like there's an awful lot of price pressures,'' said Jamie Jackson, who oversees government debt trading at RiverSource Investments, a Minneapolis firm that manages $100 billion of bonds. ``It's harder to be a credible inflation fighter if you ease into accelerating inflation.''

The Fed is done cutting rates and 10-year yields may reach 4.75 percent next quarter, Jackson said.

Futures traders are betting the slump in housing and losses in credit markets will reduce consumer confidence and trump the threat of inflation, which erodes Treasuries' fixed payments.

`Saving the Economy'

``The Fed will not only need to save the financial markets, in very short order they're going to have to start saving the economy,'' said Tom di Galoma, head of Treasury trading in New York at Jefferies & Co., a brokerage for institutional investors. The 10-year yield will fall below 4 percent by the end of June and two-year yields to 3 percent, he said.

Homebuilding declined 20 percent last quarter, the seventh straight drop, subtracting a percentage point from economic growth, government data show. The National Association of Home Builders/Wells Fargo may say today that its index of builder sentiment fell to 17 this month from an all-time low of 18 in October, according to the median forecast in a Bloomberg News survey. The index averaged 42 last year.

Plano, Texas-based J.C. Penney, the third biggest U.S. department-store company, cut its fourth-quarter profit prediction by as much as a third last week. Macy's, based in Cincinnati, lowered its fourth-quarter sales guidance.

``The Fed tends to be backward looking,'' said Lacy Hunt, chief economist at Austin, Texas-based Hoisington Investment Management Co., which is buying zero-coupon and 30-year Treasuries, the most bullish bets that inflation will cool. ``They're always looking at the way the world was, not the way it will be. Market rates reflect the buying and selling decisions of millions and millions of decision-makers.''

Hunt predicts the Fed may lower its target to 2 percent in the next few years.

Greenspan states the obvious - Central Banks reduce holdings on US Treasuries

Greenspan Says Demand for U.S. Debt May Be at `Limit' (Update1)
By Kevin Carmichael and Simon Kennedy

Oct. 21 (Bloomberg) -- Former Federal Reserve Chairman Alan Greenspan said the dollar's depreciation may reflect growing unwillingness among foreigners to buy U.S. debt.

``Obviously there is a limit to the extent that obligations to foreigners can reach,'' Greenspan said in a speech in Washington today. The dollar's decline to its lowest since 1997 may be ``an indication America is approaching this limit.''

Greenspan's warning came after the U.S. Treasury reported last week that international investors sold a record amount of U.S. financial assets in August. Total holdings of equities, notes and bonds fell a net $69.3 billion after an increase of $19.2 billion in July.

The dollar has declined about 8 percent against the euro this year and 4 percent against the yen.

The former Fed chief, who published a 531-page memoir last month, spoke for about 35 minutes before taking questions for another half hour on the sidelines of the meetings this weekend of the International Monetary Fund and World Bank. The lecture was hosted by the Per Jacobsson Foundation.

Greenspan also said that the August surge in the cost of credit after a jump in U.S. mortgage defaults was an ``accident waiting to happen,'' given that investors were pricing risk too low.

``Something had to give,'' he said. ``Had the crisis not been trigged by subprime mortgages it would have erupted in another sector or market.''

SuperSiv Fund

Greenspan, 81, was critical last week of a plan by some of the U.S.'s biggest banks to help revive the asset-backed commercial paper market, which seized up because of investor concern that too much of the paper was backed by securities containing subprime loans.

Citigroup Inc., Bank of America Corp. and JPMorgan Chase & Co. announced a plan last week to raise money for a so-called SuperSiv that would buy assets from distressed structured investment vehicles.

Investor uncertainty about the value of complex assets held by the vehicles has damped willingness to lend to the funds in the commercial paper market, stoking concern they'll have to dump holdings at fire-sale prices.

U.S. Treasury Secretary Henry Paulson, the former head of Goldman Sachs Group Inc., helped broker the agreement.

In an interview with Emerging Markets magazine published on Oct. 19, Greenspan was quoted as saying that he was unsure ``the benefits'' of the plan ``exceed the risks.''

`Best Assets'

Paulson assembled a group of reporters later that day to discuss the SIV rescue, emphasizing that the initiative was led by banks, that he had consulted the Fed and other regulators as the deal was put together, and that he was confident the initiative would work.

``The concept is not to buy bad assets or assets that have credit problems,'' Paulson said after hosting a meeting of Group of Seven finance ministers and central bank governors.

Investors will buy ``assets that aren't credit-impaired and don't have credit issues -- the very best assets,'' Paulson said. ``That will accelerate the return of liquidity to parts of this market.''

Today, Greenspan questioned whether there was any longer a market for such ``peculiar'' assets.

While he praised ``innovation'' in securitized markets as ``positive,'' he noted that demand for sales of debt backed by subprime mortgages has dried up.

`Peculiar Financial Structures'

``These peculiar financial structures that have become very prominent in the past four or five years are about to disappear from the scene,'' Greenspan said, citing ``various variations'' of collateralized debt obligations and ``special'' investment vehicles as examples.

``They have been tried and they have failed,'' Greenspan said. ``The failure is the basic way that investors have been misled as to what the value of these products is.''

The former Fed chief said central banks also increasingly appeared to have ``lost control'' of market interest rates beyond three to five years of maturity.

Much of the speech was dedicated to explaining why he doesn't view the U.S. current-account deficit with ``undue concern.''

The current-account gap, a measure of trade that includes investment flows, is now about 5.5 percent of U.S. gross domestic product, compared with 6.75 percent in 2005.

A reduction in ``home bias'' by international investors has channeled more money to the U.S., helping the country to finance its current-account deficit, Greenspan said.

He said he may become more concerned about the trade gap if ``the pernicious drift toward'' U.S. government budget deficits ``isn't arrested and compounded by protectionist reversal of globalization.''

Such a reversal would deal a ``major blow to world economic prosperity,'' he said.

Treasury yields rose yet again - Flight to safety or speculation?

Treasury Bill Yields Fall Most Since 1987 on Money Fund Demand
By Deborah Finestone and Elizabeth Stanton

Aug. 20 (Bloomberg) -- Yields on U.S. Treasury bills fell the most in two decades on demand for the safest securities amid concern over a widening credit crunch.

Bill yields have fallen five straight days as money market funds dumped asset-backed commercial paper in favor of the shortest-maturity government debt. Three-month yields dropped the most since the stock market crash of 1987 and more than in the wake of the Sept. 11, 2001, terror attacks in the U.S, as funds shunned assets that may be linked to a weakening mortgage market.

``The market is totally, absolutely, completely in fear mode,'' said John Jansen, who sells Treasuries at CastleOak Securities LP in New York. ``People are afraid that lots and lots of mortgage paper and mortgage paper derivatives of all sorts is completely opaque and they can't price it.''

The three-month Treasury bill yield fell 0.66 percentage point to 3.09 percent as of 5:06 p.m. in New York. It's the most since Oct. 20, 1987, when the yield fell 85 basis points on the day the stock market crashed, and eclipses the drop of 39 basis points on Sept. 13, 2001, the day the Treasury market reopened after the attacks. The yield has fallen from 4.69 percent on Aug. 13. The bills yielded about 7 percent in mid-October 1987 and 3.2 percent in the days before the September 2001 attacks.

``I've never seen it like this before,'' said Jim Galluzzo, who began trading short-maturity Treasuries 20 years ago and now trades bills at RBS Greenwich Capital in Greenwich, Connecticut. ``Bills right now are trading like dot-coms.''

`Get Into Treasuries'
The flight to government debt helped the U.S. Treasury sell $21 billion in three-month bills today at a high discount rate of 2.85 percent, the lowest since 2.8 percent on May 16, 2005.

Investors fled even money market funds, considered among the safest instruments, on concern that the funds, which hold $2.5 trillion, have invested in risky collateralized debt obligations backed by subprime mortgage loans.

``We had clients asking to be pulled out of money market funds and wanting to get into Treasuries,'' said Henley Smith, fixed-income manager in New York at Castleton Partners, which oversees about $150 million in bonds. ``People are buying T-bills because you know exactly what's in it.''

Institutional investors added $39.7 billion from Aug. 14 to Aug. 17 to money market funds holding primarily government securities, a 12 percent increase, according to Connie Bugbee, managing editor of the Money Fund Report newsletter in Westborough, Massachusetts. Assets in funds that may also hold commercial paper, certificates of deposit and floating-rate notes fell 2 percent, or $24.5 billion, in the same period.

TED Spread
Three-month Treasury bill yields have fallen to 2.40 percentage points less than the London interbank offered rate, from 1.74 percentage points on Aug. 17. The ``TED'' spread, as it is known, is larger than after the 1987 crash. TED originally stood for Treasury-Eurodollar.
The Federal Reserve Bank of New York said in a statement it won't re-invest the $5 billion of Treasury bill holdings maturing on Aug. 23 through its System Open Market Account to give it ``greater flexibility'' to manage reserves. It is the first time the Fed redeemed the bills since the 2001 terrorist attacks.

The move shows the Fed expects banks to borrow that much at the Fed's discount window, compared with an average $187 million borrowed daily in the past year, said Tony Crescenzi, chief bond market strategist for New York-based Miller Tabak & Co.
The yield on the benchmark two-year note fell 10 basis points to 4.08 percent. The price of the 4 5/8 percent security due in July 2009 rose about 1/8, or $1.25 per $1,000 face amount, to 100 31/32 .

Slower Economy
More than half of the 21 primary government security dealers that trade with the Fed now expect the central bank to cut its target interest rate by next month from the current level of 5.25 percent.

``The Fed is going to lower the funds rate, it's a question of when,'' said Thomas Tierney, head of U.S. Treasury trading at Citigroup Global Markets Inc. in New York. ``Credit's gotten tighter, and it's going to slow the economy.''

Interest-rate futures traders see a 100 percent chance the fed will lower its overnight lending rate between banks by its next meeting on Sept. 18. Seventy percent of those bets are for rates to drop to 4.75 percent, while the balance is for a cut to 5 percent.
The Fed on Aug. 17 cut the rate it charges banks for direct loans to banks by 0.5 percentage point to 5.75 percent. It was the first reduction in borrowing costs between scheduled meetings since 2001. The central bank said in a statement that risks to the economy have risen ``appreciably.''

Market expects Fed Funds rate to be cut to 5%

U.S. Three-Month Treasury Bill Yields Climb Most Since 2000
By Deborah Finestone and Elizabeth Stanton

Aug. 21 (Bloomberg) -- Yields on U.S. three-month Treasury bills climbed the most since 2000 as demand fell for the safest government securities.

Bill yields rose for the first day in six, after tumbling yesterday by the most since 1987. The Federal Reserve Bank of New York cut the fee bond dealers pay to borrow its Treasuries, in a bid to ease a shortage in the market for loans backed by the securities. Demand at the Treasury's sale today of $32 billion in four-week bills was the weakest since at least July 2001.

``The flight to safety may be diminishing a bit,'' said Holly Liss, a bond saleswoman in Chicago at Citigroup Global Markets Inc. ``We're seeing more calming of the market as T-bill rates come back to normal.''

The three-month bill yield climbed 0.48 percentage point to 3.57 percent at 4:28 p.m., rising for the first day since Aug. 13. The increase is the biggest since Dec. 26, 2000. Yields fell 0.66 percentage point yesterday, the most since the stock market crash of October 1987 as money-market funds dumped asset-backed commercial paper for the shortest-maturity government debt.

The Treasury today sold $32 billion of four-week bills, the largest amount since at least July 2001. The bills were sold at a high discount rate of 4.75 percent. The one-month bill yield fell as low as 1.272 percent yesterday, and was about 2.6 percent before the auction. In a sign of weak demand, the government received $1.11 in bids for each $1 sold, the lowest since at least July 2001.

Fed Cuts Fee
The New York Fed cut its so-called minimum fee rate to a record low 0.5 percent from 1 percent, saying in a statement that the move is ``temporary.''

``We are doing it to provide additional liquidity to the Treasury financing market,'' said Andrew Williams, a spokesman for the New York Fed. He said the rate was the lowest in the history of the program, which has existed in its current form since 1999. The New York Fed last lowered the fee rate on June 26, 2003, the day after policy makers cut their target overnight rate to a four-decade low of 1 percent.

The yield on the benchmark two-year note fell to a 23-month low today before Senate Banking Committee Chairman Christopher Christopher Dodd said Fed Chairman Ben S. Bernanke agreed to use ``all of the tools at his disposal'' to restore stability in financial markets roiled by the subprime mortgage crisis.

The senator addressed reporters after meeting with Bernanke and Treasury Secretary Henry Paulson in Washington today.

`Right Direction'
``The comment from Dodd and the decision from the Fed are all going in the right direction to bringing some calm back to the financing market,'' said Nicolas Beckmann, co-head of U.S. interest rates trading at BNP Paribas Securities Corp. in New York, one of the 21 primary securities dealers that trade with the Fed.

Two-year note yields fell 6 basis points to 4.02 percent. The price of the 4 5/8 percent security due in July 2009 rose about 1/8, or $1.25 per $1,000 face amount, to 101 3/32. The yield earlier touched the lowest since September 2005. The 10- year note yield declined 4 basis points to 4.59 percent.

``Bonds are in favor largely around anticipation the Fed will make some accommodation,'' said Kevin Giddis, head of fixed- income trading in Memphis, Tennessee, at Morgan Keegan Inc.

On Aug. 17, the central bank cut the rate it charges for direct loans to banks by 0.5 percentage point to 5.75 percent. It was the first reduction in borrowing costs between scheduled meetings since 2001. The central bank said in a statement that risks to the economy have risen ``appreciably.''

The Fed has kept its key monetary policy tool, the target for the overnight lending rate between banks, at 5.25 percent since June 2006.
Interest-rate futures show traders are betting the Fed will lower its overnight lending rate between banks this month. Traders see a 100 percent chance of a quarter-point cut to 5 percent, and a 51 percent chance of a half-point cut, according to the August futures contract.